Many mutual funds sell "asset allocation" products which include appropriately sized investments in a variety of asset classes meant for a prototypical investor. Some of these, such as PIMCO, even include direct commodity investments in the portfolio. Pension funds often base their investments on a model portfolio, which increasingly includes "alternatives" such as commodities. Wealth advisors and investment advisors are increasingly steering their clients towards including some small allocation to commodities, often touting the "diversification" benefits.

Question: Should the average investor be holding some commodities? Are these allocations in the interests of the client? Are there real diversification benefits to be had?

This is a question I have thought about in the past, and I thought I would post what I had found for the benefit of the community. Per the FAQ, I have phrased this as a question with my answer below.
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Tal FishmanAug 25 '11 at 17:36

No

My Take

Although there seems to be more research on the "yes" side, I would caution against concluding that this is the consensus. I have not yet found more solid "no" research pieces, but the one I did find seemed more convincing than all the others combined, most of which are actually trying to sell a product. FYI, I have done some of my own research on this topic as well, and based on that information my employer has decided not to include commodities in our strategic asset allocation product (or even in our inflation product, for which commodities are arguably (see PIMCO) more appropriate).

Interesting... FWIW, CFA Institute curriculum weighs the pros/cons and ultimately does consider commodities as an asset class. My thought is -- yes, if the asset is tied to a bona fide risk premium. For example, if a futures contract is generating a convenience yield compensating the holder for bearing risks in delivery then this would be a valid asset class.
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Quant GuyAug 26 '11 at 0:07

One well-known scientifically based passive investment fund in Germany (ARERO) draws a ratio of 15% for commodities (60% world stocks and 25% bonds, rebalanced on a yearly basis) as a conclusion out of this - see the live performance (DAX as benchmark): Here

The controversy surrounding commodity futures flows from Gorton and Rouwenthorst (2004). The authors show an equal-weight portfolio of long positions in commodity futures provides a Sharpe ratio greater than the one earned by holding a cap-weighted portfolio of U.S. stocks (beginning in the 1950's through 2004 or so).

In essence, why should holding a basket of futures contracts earn a risk premia of similar magnitude to holding claims on risky streams of future consumption?

Keynes floated the idea of "normal backwardation", a situation where the futures price trades at a discount to the expected spot price (an insurance premium provided by producers attempting to hedge future sales). This is, however, an unobservable phenomena regardless of whether commodity futures prices are in actual market backwardation or contango (downard or upward sloping price term structures).

So the search goes on to explain why a simple basket of commodity futures performs the way it does. Evidence points to the equal-weight portfolio having favorable exposure to roll yields during the 20th century. Similarly, time series momentum also seems to "work" in commodity futures, moreso with winners than losers. Hence, holding a long-only portfolio of commodity futures gives exposure to the time-series momentum effect of winners.

It may be beneficial to hold commodities, however a long-only strategy may indeed be an inefficient vehicle for accessing premia associated with roll yields and time series momentum.